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Risk aversion seems to be on the rise again after some respite over last month.
That is what the renewed strength of the US dollar in the New Year despite weakening fundamentals is indicating.

Last week, the greenback rallied against the euro and some of the other major currencies, despite US economic data, particularly the employment numbers, pointing towards acute weakness in the US economy.

The US dollar advanced, posting strong gains in the first half of the week before losing some ground after worse-than-expected US private sector employment figures on Wednesday. That kept the greenback in check until Friday’s non-farm employment report.

The US dollar resumed its strong run after the non-farm payroll report showed that the US economy shed 524,000 jobs outside the agricultural sector in December, less than the consensus forecast. Over the week the greenback rose by 3.2% against the ero to a three-week high, went up 2.8% against the Swiss franc and gained 1% against the Australian dollar.

The euro also suffered losses due to deteriorating Euro-zone economic data which heightened the prospects for further interest rate cuts in the region. The sharp fall in the single currency last week came after a strong run that saw it hit several trade-weighted highs in December.

The euro had benefited last month not only from year-end demand but also from the relatively hawkish tone coming from the European Central Bank (ECB).

The ECB president, Jean-Claude Trichet, had hinted that the central bank would keep interest rates on hold at this week’s policy meeting as it monitored the effect of previous rate cuts. But with Eurozone inflation plunging below the ECB’s target in December and a series of bad economic data points — including the first rise in German unemployment for nearly three years — expectations of an ECB rate cut heightened. Over the week, the euro plunged 7.3% to a three-week trough against the pound.

The pound turned out to be the out-performer among the major global currecnies last week. It soared as the Bank of England slowed the pace of interest rate cuts in the UK. Although the BOE lowered interest rates by 0.5% to a record low of 1.5% after its policy meeting on Thursday, the pound rallied because a large section of the market had been expecting a large cut. There was even some speculation of a 1% rate cut.

Over the week, the pound rose 4.4% to a three-week high against the US dollar, 2.3% against the Japanese yen and 7.3% against the Swiss franc.

The en advanced as the recent rally in equities ran out of steam, boosting risk aversion and safe-haven demand for the Japanese currency. Over the week, the yen rose 2.1% against the greenback, 5.2% against the euro and 3.1% against the Australian dollar.
In the local inter-bank market, rupee appreciated by 0.6% against the US dollar over the week.

Dollar demand from importers and other corporates, a sharp slide in the stock market after the Satyam news and greenback’s global strength pushed the Indian unit lower until Friday.

On the last day of the week however, the rupee recovered most its losses swiftly, as banks unwound their long dollar position following some stability in the stock market. Some exporters’ also offloaded dollars, as the rupee-dollar pair hit a key technical resistance level of 49.30.

The FIIs net purchase of Indian stocks and bonds to the tune of $474.4 million also helped the Indian unit. Over the week the rupee-dollar pair traded in the range of 48.10 - 49.30.

This week’s currency movements will be influenced by a key event scheduled for Tuesday. The US Federal Reserve chairman Ben Bernanke will speak in London on the financial crisis and policy response, and this could prove to be one of the biggest market-movers of the week due to its potential impact on risk sentiment.

If Bernanke is bearish on prospects for the global economy, his comments could have negative repercussions for the stock markets, and we could see flight-to-safety spark demand for the US dollar and the Japanese yen. On the other hand, if Bernanke signals any new type of policy action or if he manages to inspire market confidence that conditions will not get significantly worse, risky assets could rally.

Economic indicators to watch this week include advance US retail sales, which are forecasted to show that overall retail sales contracted for the sixth straight month in December. Importantly, the release of the December US CPI inflation data could lead the term “deflation” to be used frequently in coming months.

The annual rate of CPI inflation is forecasted to have turned negative for the first time since 1955 by 0.1%. That could weigh on the US dollar, as deflationary conditions would warrant a continuation of quantitative easing policy by the Fed, which in turn would entail massively increasing the supply of dollars.

The return of risk aversion in the global markets could however, continue to keep the rupee under pressure. And, any further strengthening of the greenback on the back of that would pull rupee lower.

In terms of fundamentals too, rupee could be under pressure this week. The index of Industrial Production (IIP) data for November are due for release on Monday. The October IIP growth had printed at a -0.4% yoy and the November number is likely to be much worse. That is likely to drag the stocks and rupee lower. Overall the rupee-dollar pair can trade in the range of 48.30 - 49.30 this week.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com